**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

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**FORM 10-Q**

 

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| ý                                                                                                                                                                                                                                                                              | **QUARTERLY  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF  1934**  |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|-----------------------------------------------------------------------------------------------------|
|                                                                                                                                                                                                                                                                                |
| **For the quarterly period ended June 30, 2004**                                                                                                                                                                                                                               |
|                                                                                                                                                                                                                                                                                |
| **OR**                                                                                                                                                                                                                                                                              |
|                                                                                                                                                                                                                                                                                |
| o                                                                                                                                                                                                                                                                                   | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF  1934** |
|                                                                                                                                                                                                                                                                                |
| For  the transition period from                   to                        |
|                                                                                                                                                                                                                                                                                |
| **Commission File Number   0-20191**                                                                                                                                                                                                                                           |

 

**INTRUSION INC.**

(Exactname of Registrant as specified in its charter)

 
| **Delaware**                                                     | ** ** | **75-1911917**                         |
|------------------------------------------------------------------|------------|----------------------------------------|
| (State  or other jurisdiction of  incorporation or organization) |       | (I.R.S.  Employer  Identification No.) |

 

**1101 East Arapaho Road, Richardson, Texas 75081**

(Addressof principal executive offices)

(ZipCode)

 

**(972) 234-6400**

(Registrant’stelephone number, including area code)

 

**Not Applicable**

Formername, if changed since last report)

 

** * * * * * * * *

 

Indicate by check markwhether the Registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that the Registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days:

Yes ý No o

 

Indicate by check markwhether the Registrant is an accelerated filer (as defined in Rule 12b-2 of theExchange Act).  Yes o No ý

 

The number of sharesoutstanding of the Registrant’s Common Stock, $0.01 par value, onAugust 13, 2004 was 5,166,312.

 

 

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**INTRUSION INC.**

 

INDEX

 
| **PART I – FINANCIAL INFORMATION**                                                                           |   |
|-------------------------------------------------------------------------------------------------------------------|--------|
|                                                                                                              |   |
| Item 1.  Financial Statements                                                                                |   |
|                                                                                                              |   |
| Condensed  Consolidated Balance Sheets as of June 30, 2004 and December 31,  2003                       |   |
|                                                                                                              |   |
| Condensed  Consolidated Statements of Operations for the three and six months ended  June 30, 2004 and 2003. |   |
|                                                                                                              |   |
| Condensed  Consolidated Statements of Cash Flows for the six months ended June 30,  2004 and 2003            |   |
|                                                                                                              |   |
| Notes to  Condensed Consolidated Financial Statements                                                             |   |
|                                                                                                              |   |
| Item 2.   Management’s Discussion and Analysis of Financial Condition and  Results of Operations        |   |
|                                                                                                              |   |
| Item 3.   Quantitative and Qualitative Disclosures About Market Risk                                         |   |
|                                                                                                              |   |
| Item 4.   Controls and Procedures                                                                            |   |
|                                                                                                              |   |
| **PART II – OTHER INFORMATION**                                                                              |   |
|                                                                                                              |   |
| Item 1.   Legal Proceedings                                                                                  |   |
|                                                                                                              |   |
| Item  4.  Submission of Matters to a Vote of  Security Holders                                               |   |
|                                                                                                              |   |
| Item 6.   Exhibits and Reports on Form 8-K                                                                   |   |
|                                                                                                              |   |
| Signature Page                                                                                                    |   |

 

2

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**PART I****– FINANCIAL INFORMATION**

 

Item 1. FINANCIAL STATEMENTS

 

**INTRUSION INC. AND SUBSIDIARIES**

CONDENSEDCONSOLIDATED BALANCE SHEETS

(Inthousands, except par value amounts)

 
| ** **                                                                                                                                                                 | ** ** | **June**** 30,  2004** | ** ** | **December**** 31,  2003** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|---------------------------------|------------|
| ** **                                                                                                                                                                 | ** ** | **(Unaudited)**             | ** ** | **(Audited)**                   | ** ** |
| **ASSETS**                                                                                                                                                                 |       |                        |       |                            |       |
| Current Assets:                                                                                                                                                            |       |                        |       |                            |       |
| Cash and cash equivalents                                                                                                                                                  |       | $                           | 1,636      |                            | $          | 974 |   |
| Short-term investments                                                                                                                                                     |       | 3,100                       |       | 1,705                           |       |
| Accounts receivable, less allowance for  doubtful accounts of $574 in 2004 and $574 in 2003                                                                                |       | 588                         |       | 972                             |       |
| Inventories, net                                                                                                                                                           |       | 1,382                       |       | 1,286                           |       |
| Other assets                                                                                                                                                               |       | 253                         |       | 449                             |       |
| Total current  assets                                                                                                                                                 |       | 6,959                       |       | 5,386                           |       |
| Property and equipment, net                                                                                                                                                |       | 234                         |       | 297                             |       |
| Other assets                                                                                                                                                               |       | 77                          |       | 77                              |       |
| TOTAL ASSETS                                                                                                                                                               |       | $                           | 7,270      |                            | $          | 5,760 |   |
|                                                                                                                                                                       |       |                        |       |                            |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                              |       |                        |       |                            |       |
|                                                                                                                                                                       |       |                        |       |                            |       |
| Current Liabilities:                                                                                                                                                       |       |                        |       |                            |       |
| Accounts payable and accrued expenses                                                                                                                                      |       | $                           | 1,692      |                            | $          | 2,188 |   |
| Deferred revenue                                                                                                                                                           |       | 919                         |       | 788                             |       |
| Total current liabilities                                                                                                                                                  |       | 2,611                       |       | 2,976                           |       |
| Stockholders’ Equity:                                                                                                                                                 |       |                        |       |                            |       |
| Preferred stock, $.01 par value, authorized  shares – 5,000; 1,000 shares issued and outstanding, liquidation preference  $5,000                                      |       | 3,534                       |       | —                          |       |
| Common stock, $.01 par value, authorized  shares - 80,000; issued shares – 5,176 in 2004 and 5,173 in 2003; outstanding  shares – 5,166 in 2004and 5,163 in 2003 |       | 52                          |       | 52                              |       |
| Common stock held in treasury, at cost – 10  shares                                                                                                                   |       | (362                        | )          | (362                            | )          |
| Additional paid-in capital                                                                                                                                                 |       | 48,661                      |       | 47,526                          |       |
| Accumulated deficit                                                                                                                                                        |       | (46,998                     | )          | (44,204                         | )          |
| Accumulated other comprehensive loss                                                                                                                                       |       | (228                        | )          | (228                            | )          |
| Total stockholders’ equity                                                                                                                                            |       | 4,659                       |       | 2,784                           |       |
| TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                                                            |       | $                           | 7,270      |                            | $          | 5,760 |   |

 

Seeaccompanying notes.

 

3

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**INTRUSION INC. AND SUBSIDIARIES**CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS(In thousands, except per share amounts)(Unaudited)

 
| ** **                                                                  | ** ** | **Three Months Ended**  | ** ** | **Six Months Ended**    | ** ** |
|-----------------------------------------------------------------------------|------------|-------------------------|------------|-------------------------|------------|
| ** **                                                                  | ** ** | **June 30,  2004** | ** ** | **June 30,  2003** | ** ** | **June 30,  2004** | ** ** | **June 30,  2003** | ** ** |
| Net product revenue                                                         |       | $                       | 644        |                    | $          | 768 |   | $ | 1,215 |   | $ | 1,659 |   |
| Net customer support and maintenance  revenue                               |       | 459                     |       | 715                     |       | 1,155 |   | 1,300 |   |
| Total revenue                                                               |       | 1,103                   |       | 1,483                   |       | 2,370 |   | 2,959 |   |
| Cost of product revenue                                                     |       | 453                     |       | 712                     |       | 728 |   | 1,565 |   |
| Cost of customer support and maintenance  revenue                           |       | 124                     |       | 379                     |       | 485 |   | 530 |   |
| Total cost of revenue                                                       |       | 577                     |       | 1,091                   |       | 1,213 |   | 2,095 |   |
|                                                                        |       |                    |       |                    |       |   |   |   |   |
| Gross profit                                                                |       | 526                     |       | 392                     |       | 1,157 |   | 864 |   |
|                                                                        |       |                    |       |                    |       |   |   |   |   |
| Operating expenses:                                                         |       |                    |       |                    |       |   |   |   |   |
| Sales and marketing                                                         |       | 1,013                   |       | 1,923                   |       | 1,973 |   | 3,786 |   |
| Research and development                                                    |       | 732                     |       | 901                     |       | 1,334 |   | 1,824 |   |
| General and administrative                                                  |       | 315                     |       | 446                     |       | 579 |   | 848 |   |
| Severance costs                                                             |       | 34                      |       | 118                     |       | 130 |   | 244 |   |
|                                                                        |       |                    |       |                    |       |   |   |   |   |
| Operating loss                                                              |       | (1,568                  | )          | (2,996                  | )          | (2,859 | ) | (5,838 | ) |
|                                                                        |       |                    |       |                    |       |   |   |   |   |
| Other income                                                                |       | 40                      |       | 10                      |       | 40 |   | 10 |   |
| Interest income, net                                                        |       | 7                       |       | 53                      |       | 26 |   | 114 |   |
|                                                                        |       |                    |       |                    |       |   |   |   |   |
| Loss before income tax provision                                            |       | (1,521                  | )          | (2,933                  | )          | (2,793 | ) | (5,714 | ) |
|                                                                        |       |                    |       |                    |       |   |   |   |   |
| Income tax provision                                                        |       | —                  |       | —                  |       | — |   | — |   |
|                                                                        |       |                    |       |                    |       |   |   |   |   |
| Net loss                                                                    |       | $                       | (1,521     | )                       | $          | (2,933 | ) | $ | (2,793 | ) | $ | (5,714 | ) |
|                                                                        |       |                    |       |                    |       |   |   |   |   |
| Preferred stock dividends accrued                                           |       | (62                     | )          | —                  |       | (62 | ) | — |   |
| Beneficial conversion feature on preferred  stock                           |       | —                  |       | —                  |       | (938 | ) | — |   |
| Net loss attributable to common  stockholders                               |       | $                       | (1,583     | )                       | $          | (2,933 | ) | $ | (3,793 | ) | $ | (5,714 | ) |
|                                                                        |       |                    |       |                    |       |   |   |   |   |
| Net loss per share attributable to common  stockholders (basic and diluted) |       | $                       | (0.31      | )                       | $          | (0.57 | ) | $ | (0.73 | ) | $ | (1.11 | ) |
|                                                                        |       |                    |       |                    |       |   |   |   |   |
| Weighted average common shares outstanding,  basic and diluted              |       | 5,166                   |       | 5,162                   |       | 5,165 |   | 5,162 |   |

 

Seeaccompanying notes.

 

4

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**INTRUSION INC. AND SUBSIDIARIES**CONDENSED CONSOLIDATED STATEMENTSOF CASH FLOWS(In thousands)(Unaudited)

 
| ** **                                                                  | ** ** | **Six Months Ended**    | ** ** |
|-----------------------------------------------------------------------------|------------|-------------------------|------------|
| ** **                                                                  | ** ** | **June 30,  2004** | ** ** | **June 30,  2003** | ** ** |
| Operating Activities:                                                       |       |                    |       |   |   |
| Net loss                                                                    |       | $                       | (2,793     | ) | $ | (5,714 | ) |
| Adjustments to reconcile net loss to net  cash used in operating activities |       |                    |       |   |   |
| Depreciation and amortization                                               |       | 144                     |       | 850 |   |
| Provision for doubtful accounts                                             |       | —                  |       | (290 | ) |
| Changes in operating assets and liabilities:                                |       |                    |       |   |   |
| Accounts receivable                                                         |       | 384                     |       | 1,692 |   |
| Inventories                                                                 |       | (96                     | )          | (145 | ) |
| Other assets                                                                |       | 196                     |       | 423 |   |
| Accounts payable and accrued expenses                                       |       | (558                    | )          | (872 | ) |
| Deferred revenue                                                            |       | 131                     |       | (502 | ) |
| Net cash used in operating activities                                       |       | (2,592                  | )          | (4,558 | ) |
| Investing Activities:                                                       |       |                    |       |   |   |
| Purchases of short-term investments                                         |       | (3,100                  | )          | (2,150 | ) |
| Maturities of short-term investments                                        |       | 1,705                   |       | 4,925 |   |
| Net purchases of property and equipment                                     |       | (82                     | )          | (85 | ) |
| Net cash provided by investing activities                                   |       | (1,477                  | )          | 2,690 |   |
| Financing Activities:                                                       |       |                    |       |   |   |
| Proceeds from the exercise of employee  stock options                       |       | 6                       |       | — |   |
| Proceeds from the issuance of preferred  stock and warrants, net            |       | 4,725                   |       | — |   |
| Net cash provided by financing activities                                   |       | 4,731                   |       | — |   |
|                                                                        |       |                    |       |   |   |
| Net increase (decrease) in cash and cash  equivalents                       |       | 662                     |       | (1,868 | ) |
| Cash and cash equivalents at beginning of  period                           |       | 974                     |       | 2,898 |   |
| Cash and cash equivalents at end of period                                  |       | $                       | 1,636      |   | $ | 1,030 |   |
|                                                                        |       |                    |       |   |   |
| SUPPLEMENTAL DISCLOSURE OF NON CASH  FINANCING ACTIVITIES:                  |       |                    |       |   |   |
|                                                                        |       |                    |       |   |   |
| Fair value of warrants issued in connection  with sale of preferred stock   |       | $                       | 1,191      |   | $ | — |   |
| Amortization of preferred stock beneficial  conversion feature              |       | $                       | 938        |   | $ | — |   |
| Preferred stock dividend accrued                                            |       | $                       | 62         |   | $ | — |   |

 

Seeaccompanying notes.

 

5

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**INTRUSION INC. AND SUBSIDIARIES**

NOTES TO CONDENSEDCONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

 

1.               Description of Business

 

We develop,market and support a family of network intrusion prevention and detection systemsand regulated information compliance systems that address vital security issuesfacing organizations with mission critical business applications or housingclassified, confidential, or customer information assets.  We currently provide network security andregulated information compliance solutions under our SecureNetfamily of hardware and software solutions.

 

We market and distribute ourproducts through a direct sales force to end-users and distributors and bynumerous domestic and international system integrators, managed serviceproviders and value-added resellers.  Ourend-user customers include high technology, manufacturing, telecommunications,retail, transportation, health care, insurance, entertainment, utilities andenergy companies, government entities, financial institutions, and academicinstitutions.

 

We were organized in Texasin September 1983 and reincorporated in Delaware inOctober 1995.  For more than 15years, we provided local area networking equipment and were known as Optical DataSystems or ODS Networks.  OnApril 17, 2000, we announced plans to sell, or otherwise dispose of, ournetworking divisions, which included our Essential Communications division andour local area networking assets.  Inaccordance with these plans, we have accounted for these businesses asdiscontinued operations.  On June 1,2000, we changed our name from ODS Networks, Inc. to Intrusion.com, Inc., andour NASDAQ ticker symbol from ODSI to INTZ to reflect our focus on intrusiondetection solutions.  On November 1,2001, we changed our name from Intrusion.com, Inc. to Intrusion Inc.

 

Our principal executiveoffices are located at 1101 East Arapaho Road, Richardson, Texas 75081, and ourtelephone number is (972) 234-6400.  Ourwebsite URL is www.intrusion.com. Information contained in or linked to our website are not a part of thisreport.  References to “we,” “us” and“our” in this report refer to Intrusion Inc. and its subsidiaries.

 

As of June 30, 2004, wehad cash, cash equivalents and short-term investments in the amount ofapproximately $4.7 million, up from approximately $2.7 million as ofDecember 31, 2003.  Although webelieve we have sufficient cash resources to finance our operations andexpected capital expenditures for the next twelve months, based on our internalestimates and our operating plan, the sufficiency of our cash resources maydepend to a certain extent on general economic, financial, competitive or otherfactors beyond our control.  Moreover, despiteactions to reduce our costs and improve our profitability, we expect ouroperating losses and net operating cash outflows to continue through 2004.  As a result, we may not be able to achievethe revenue and gross margin objectives necessary to achieve positive cash flowor profitability without obtaining additional financing.  We do not currently have any arrangements forfinancing and we may not be able to secure additional debt or equity financingon terms acceptable to us, or at all, at the time when we need suchfunding.  If our business does notgenerate sufficient cash flow from operations and sufficient future financingsare not available, we may not be able to operate or grow our business, pay ourexpenses when due or fund our other liquidity needs.

 

6

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2.               Basis of Presentation

 

The accompanying unaudited condensed consolidated financial statements havebeen prepared in accordance with accounting principles generally accepted inthe United States for interim financial information and with the instructionsto Form 10-Q and Article 10 of Regulation S-X.  Accordingly, they do not include all of theinformation and footnotes required by accounting principles generally acceptedin the United States for complete financial statements.  The December 31, 2003 balance sheet wasderived from audited financial statements, but does not include all thedisclosures required by accounting principles generally accepted in the UnitedStates.  However, we believe that thedisclosures are adequate to make the information presented not misleading.  In our opinion, all the adjustments(consisting of normal recurring adjustments) considered necessary for fairpresentation have been included.  Theresults of operations for the three months ending June 30, 2004 are notnecessarily indicative of the results that may be achieved for the full fiscalyear or for any future period.  Thecondensed consolidated financial statements included herein should be read inconjunction with the consolidated financial statements and notes theretoincluded in the Company’s annual report on Form 10-K for the year endedDecember 31, 2003.

 

3.               Inventories (In thousands)

 
| ** **              | ** ** | **June 30,  2004** | ** ** | **December 31,  2003** | ** ** |
|-------------------------|------------|-------------------------|------------|-----------------------------|------------|
|                    |       |                    |       |                        |       |
| Inventories consist of: |       |                    |       |                        |       |
|                    |       |                    |       |                        |       |
| Finished goods          |       | $                       | 1,008      |                        | $          | 851 |   |
| Work in progress        |       | 146                     |       | 261                         |       |
| Demonstration systems   |       | 228                     |       | 174                         |       |
| Net inventory           |       | $                       | 1,382      |                        | $          | 1,286 |   |

 

4.               Accounting for Stock-Based Compensation

 

We account for employeestock-based compensation under APB 25. The following table summarizes relevant information as to the reportedresults under our intrinsic value method of accounting for stock awards, withsupplemental information as if the fair value recognition provision of SFAS 123as amended by SFAS 148 had been applied for the quarters ended June 30,2004 and June 30, 2003 (in thousands, except per share data).  All stock information in this report reflectsa four-for-one (4:1) reverse stock split completed on March 29, 2004:

 

7

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| ** **                                                                                                  | ** ** | **Quarter  Ended  June 30,  2004** | ** ** | **Quarter  Ended  June 30,  2003** | ** ** | **Six  Months  June 30,  2004** | ** ** | **Six  Months  June 30,  2003** | ** ** |
|-------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------|------------|-----------------------------------------|------------|--------------------------------------|------------|--------------------------------------|------------|
|                                                                                                        |       |                                    |       |                                    |       |                                 |       |                                 |       |
| Net loss attributable to common  stockholders                                                               |       | $                                       | (1,583     | )                                       | $          | (2,933                               | )          | $                                    | (3,793     | ) | $ | (5,714 | ) |
| Add (Deduct):  Total stock-based compensation determined under  fair value-based method for all awards |       | (46                                     | )          | 4                                       |       | (119                                 | )          | 336                                  |       |
| Pro forma net loss attributable to common  stockholders                                                     |       | $                                       | (1,629     | )                                       | $          | (2,929                               | )          | $                                    | (3,912     | ) | $ | (5,378 | ) |
| Net loss per share attributable to common  stockholders:                                                    |       |                                    |       |                                    |       |                                 |       |                                 |       |
| as reported (basic and diluted)                                                                             |       | $                                       | (0.31      | )                                       | $          | (0.57                                | )          | $                                    | (0.73      | ) | $ | (1.11 | ) |
| pro forma (basic and diluted)                                                                               |       | $                                       | (0.32      | )                                       | $          | (0.57                                | )          | $                                    | (0.76      | ) | $ | (1.04 | ) |
| Weighted-average shares used in  computation:                                                               |       |                                    |       |                                    |       |                                 |       |                                 |       |
| Basic and diluted                                                                                           |       | 5,166                                   |       | 5,162                                   |       | 5,165                                |       | 5,162                                |       |

 

As required, the pro formadisclosures above include options granted since January 1, 1995.  Consequently, the effects of applying SFAS123 and SFAS 148 for providing pro forma disclosures may not be representativeof the effects on reported operating results for future years until all optionsoutstanding are included in the pro forma disclosures.  For purposes of pro forma disclosures, theestimated fair value of stock-based compensation plans and other options areamortized to expense primarily over the vesting period.

 

5.               Net Loss Per Share

 

We report two separateearnings per share (“EPS”) numbers, basic EPS and diluted EPS.  Basic net loss per share is computed bydividing net loss attributable to common stockholders for the period by theweighted average number of common shares outstanding for the period.  Diluted net loss per share is computed bydividing the net loss attributable to common stockholders by the weightedaverage number of common shares and common stock equivalents outstanding forthe period.  Our common stock equivalentsinclude all common stock issuable upon conversion ofconvertible preferred stock and the exercise of outstanding options andwarrants.  The aggregate number of commonstock equivalents excluded from the loss per share calculation for the threeand six-month periods ended June 30, 2004 and 2003 are 2,594,849 and377,095, respectively.  Our common stockequivalents are not included in the diluted loss per share for the three andsix-month periods ended June 30, 2004 and 2003, as they are antidilutive.

 

8

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6.               Commitments and Contingencies

 

We are subject to legalproceedings and claims that arise in the ordinary course of business.  We do not believe that the outcome of thosematters, if any, will have a material adverse affect on our consolidatedfinancial position, operating results or cash flows.  However, there can be no assurance such legalproceedings will not have a material impact.

 

Item2.                                MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIALCONDITION AND RESULTS OF OPERATIONS

 

This report containsforward-looking statements, within the meaning of Section 27A of theSecurities Act of 1933 and Section 21E of the Securities Exchange Act of1934, that involve risks and uncertainties, such as statements concerning: thedifficulties in forecasting future sales caused by current economic and marketconditions, the effect of military actions on government and corporate spendingon information security products, spending patterns of, and appropriations to,U.S. government departments, the impact of our cost reduction programs and ourrefocused product line, the difficulties and uncertainties in successfullydeveloping and introducing new products, our ability to continue to meetoperating expenses through current cash flow or additional financings, thehighly competitive market for our products, difficulties in accuratelyestimating market growth, the consolidation of the information securityindustry, the impact of changing economic conditions, business conditions inthe information security industry, our ability to manage acquisitionseffectively, our ability to manage discontinued operations effectively, theimpact of market peers and their products as well as risks concerning futuretechnology and others identified in our Annual Report on Form 10-K, as amended,and other Securities and Exchange Commission filings.  Such forward-looking statements are generallyaccompanied by words such as “plan,” “estimate,” “expect,” “believe,” “should,”“would,” “could,” “anticipate,” “may” or other words that convey uncertainty offuture events or outcomes.  Theseforward-looking statements and other statements made elsewhere in this reportare made in reliance on the Private Securities Litigation Reform Act of1995.  The section below entitled“Factors That May Affect Future Results of Operations” sets forth andincorporates by reference certain factors that could cause actual futureresults of the company to differ materially from these statements.

 

Critical Accounting Policiesand Estimates

 

Management’s discussion andanalysis of financial condition and results of operations are based upon ourcondensed consolidated financial statements, which have been prepared inaccordance with accounting principles generally accepted in the UnitedStates.  The preparation of thesefinancial statements requires us to make estimates and judgments that affectthe reported amounts of assets, liabilities, revenues and expenses, and relateddisclosure of contingent assets and liabilities.  On an on-going basis, we evaluate ourestimates, including those related to product returns, bad debts, inventories,income taxes, warranty obligations, restructuring, maintenance contracts andcontingencies.  We base our estimates onhistorical experience and on various other assumptions that are believed to bereasonable under the circumstances, the results of which form the basis formaking judgments about the carrying values of assets and liabilities that arenot readily apparent from other sources. Actual results may differ from these estimates under differentassumptions or conditions.

 

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We believe the followingcritical accounting policies affect our more significant judgments and estimatesused in the preparation of our condensed consolidated financial statements.

 

*RevenueRecognition*

 

We generally recognizeproduct revenue upon shipment of product. We accrue for estimated warrantycosts and sales returns at the time of shipment based on our experience.Revenue from maintenance contracts is deferred and recognized over thecontractual period the services are performed, generally one year.  There is a risk that technical issues on newproducts could result in unexpected warranty costs and returns.  However, as we migrate to more of asoftware-based business model, our warranty costs should continue todecline.  To the extent that they dodecline, our warranty reserve from current sales will decrease.  If our warranty costs exceed our expectations,we will increase our warranty reserve to compensate for the additional expenseexpected to be incurred.  We review theseestimates periodically and determine the appropriate reserve percentage.  However, to date, warranty costs and salesreturns have not been material. Historically, our estimates for these items have not differed materiallyfrom actual results.  We believe that ourrevenue recognition policy does not include significant or subjectiveestimates.

 

We recognize softwarerevenue from the licensing of our software products in accordance withStatement of Position (“SOP”) No. 97-2 “Software Revenue Recognition”, SOP 98-9“Modification of 97-2, Software Revenue Recognition, with respect to certaintransactions” and Staff Accounting Bulletin (“SAB”) No. 104, “RevenueRecognition” whereby revenue from the licensing of our products is notrecognized until all four of the following have been met: i)execution of a written agreement; ii) delivery of the product has occurred;iii) the fee is fixed and determinable; and iv) collectibilityis probable. Bundled hardware and perpetual software product sales arerecognized at time of delivery, as our licenses are not sold on a subscriptionbasis.  In the case of multiple productand service sales, we perform a Vendor Specific Objective Evidence analysis toappropriately determine the amount of revenue derived from eachdeliverable.  If our license strategychanges and we begin to offer licenses on a subscription basis, we wouldperform this analysis in a similar manner. Under these circumstances, the revenue related to the license would berecognized ratably over the subscription period.  Market values are easily obtained for all ofour product offerings, as we have historical sales information on our productofferings.  We defer and recognizemaintenance and support revenue over the term of the contract period, which isgenerally one year.

 

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We have signed distributionagreements with distributors in the United States, Europe and Asia. In general,these relationships are non-exclusive. Distributors typically maintain aninventory of our products. Under these agreements, we provide certainprotection to the distributors for their inventory of our products for pricereductions as well as products that are slow moving or have been discontinuedby us.  Historically, returns from ourdistributors and charges related to price reductions on inventory held bydistributors have not been material. Recognition of sales to distributors and related gross profits aredeferred until the distributors resell the merchandise. However, since we havelegally sold the inventory to the distributor and we no longer have care,custody or control over the inventory, we recognize the trade accountsreceivable and reduce inventory related to the sale at the time of shipment tothe distributor. Revenue, offset by deferred cost of sales, is included indeferred revenue in the accompanying financial statements.  Since the net balance in Deferred Revenuerepresents the sales price less the cost of the product maintained by thedistributors, the deferred costs of these products are included in ourobsolescence and slow-moving analysis and are written down according to theircurrent value.  This transaction,effectively recognizes expense for the write-down, if any, and increases thenet liability in the deferred revenue account.

 

We generally recognizeservice revenue upon delivery of the contracted service.  Service revenue, primarily includingmaintenance, training and installation are recognized upon delivery of theservice and typically are unrelated to product sales.  These services are not essential to thefunctionality of the delivered product. To date, training and installation revenue has not been material.

 

*Allowancefor Doubtful Accounts and Returns*

 

Trade accounts receivableare stated at the amount we expect to collect. We maintain allowances for doubtful accounts for estimated lossesresulting from the inability of our customers to make required payments.  Management considers the following factorswhen determining the collectibility of specificcustomer accounts:  customercredit-worthiness, past transaction history with the customer, current economicindustry trends, and changes in customer payment terms.  If the financial condition of our customerswere to deteriorate, adversely affecting their ability to make payments,additional allowances would be required. Based on management’s assessment, we provide for estimated uncollectibleamounts through a charge to earnings and a credit to a valuationallowance.  Balances thatremain outstanding after we have used reasonable collection efforts arewritten off through a charge to the valuation allowance and a credit toaccounts receivable.  Historically, ourestimates for sales returns and doubtful accounts have not materially differedfrom actual results.

 

*Inventory*

 

We write down our inventoryfor estimated obsolescence or unmarketable inventory equal to the differencebetween the cost of inventory and the estimated market value based uponassumptions about future demand and market conditions. If actual marketconditions are less favorable than those projected by management, additionalinventory write-downs may be required. Historically, our estimates for inventory obsolescence have not differedmaterially from actual results.

 

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Results of Operations

 

The following table setsforth, for the periods indicated, certain financial data as a percentage of netrevenues. The period-to-period comparison of financial results is notnecessarily indicative of future results.

 
| ** **                                        | ** ** | **Three Months Ended**      | ** ** | **Six Months Ended**        | ** ** |
|---------------------------------------------------|------------|-----------------------------|------------|-----------------------------|------------|
| ** **                                        | ** ** | **June**** 30,  2004** | ** ** | **June**** 30,  2003** | ** ** | **June**** 30,  2004** | ** ** | **June**** 30,  2003** | ** ** |
| Net product revenue                               |       | 58.4                        | %          | 51.8                        | %          | 51.3 | % | 56.1 | % |
| Net customer support and maintenance  revenue     |       | 41.6                        |       | 48.2                        |       | 48.7 |   | 43.9 |   |
| Total revenue                                     |       | 100.0                       |       | 100.0                       |       | 100.0 |   | 100.0 |   |
| Cost of product revenue                           |       | 41.1                        |       | 48.0                        |       | 30.7 |   | 52.9 |   |
| Cost of customer support and maintenance revenue  |       | 11.2                        |       | 25.6                        |       | 20.5 |   | 17.9 |   |
| Total cost of revenue                             |       | 52.3                        |       | 73.6                        |       | 51.2 |   | 70.8 |   |
| Gross profit                                      |       | 47.7                        |       | 26.4                        |       | 48.8 |   | 29.2 |   |
| Operating expenses:                               |       |                        |       |                        |       |   |   |   |   |
| Sales and marketing                               |       | 91.8                        |       | 129.7                       |       | 83.2 |   | 127.9 |   |
| Research and development                          |       | 66.4                        |       | 60.8                        |       | 56.3 |   | 61.6 |   |
| General and administrative                        |       | 28.6                        |       | 30.1                        |       | 24.4 |   | 28.7 |   |
| Severance costs                                   |       | 3.1                         |       | 8.0                         |       | 5.5 |   | 8.2 |   |
| Operating loss                                    |       | (142.2                      | )          | (202.2                      | )          | (120.6 | ) | (197.2 | ) |
|                                              |       |                        |       |                        |       |   |   |   |   |
| Other income                                      |       | 3.6                         |       | 0.7                         |       | 1.7 |   | 0.3 |   |
| Interest income, net                              |       | 0.6                         |       | 3.6                         |       | 1.1 |   | 3.9 |   |
| Loss before income tax provision                  |       | (137.9                      | )          | (197.9                      | )          | (117.8 | ) | (193.0 | ) |
|                                              |       |                        |       |                        |       |   |   |   |   |
| Income tax provision                              |       | —                      |       | —                      |       | — |   | — |   |
|                                              |       |                        |       |                        |       |   |   |   |   |
| Net loss                                          |       | (137.9                      | )%         | (197.9                      | )%         | (117.8 | )% | (193.0 | )% |
| Preferred stock dividends accrued                 |       | (5.6                        | )          | —                      |       | (2.6 | ) | — |   |
| Beneficial conversion feature on preferred  stock |       | —                      |       | —                      |       | (39.6 | ) | — |   |
|                                              |       |                        |       |                        |       |   |   |   |   |
| Net loss attributable to common  stockholders     |       | (143.5                      | )%         | (197.9                      | )%         | (160.0 | )% | (193.0 | )% |

 

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| ** **          | ** ** | **Three Months Ended**      | ** ** | **Six Months Ended**        | ** ** |
|---------------------|------------|-----------------------------|------------|-----------------------------|------------|
| ** **          | ** ** | **June**** 30,  2004** | ** ** | **June**** 30,  2003** | ** ** | **June**** 30,  2004** | ** ** | **June**** 30,  2003** | ** ** |
| Domestic revenues   |       | 84.6                        | %          | 66.6                        | %          | 73.7 | % | 57.6 | % |
| Export revenues to: |       |                        |       |                        |       |   |   |   |   |
| Europe              |       | 5.7                         |       | 24.6                        |       | 16.6 |   | 30.9 |   |
| Canada              |       | 7.5                         |       | 1.9                         |       | 5.5 |   | 0.6 |   |
| Asia                |       | 1.9                         |       | 6.6                         |       | 3.9 |   | 10.8 |   |
| Latin America       |       | 0.3                         |       | 0.3                         |       | 0.3 |   | 0.1 |   |
|                |       |                        |       |                        |       |   |   |   |   |
| Net revenues        |       | 100.0                       | %          | 100.0                       | %          | 100.0 | % | 100.0 | % |

 

**Net Revenues**.  Net revenues for the quarter and six monthsended June 30, 2004 were $1.1 million and $2.4 million, respectively,compared to $1.5 million and $3.0 million for the same periods in 2003.  Product revenues decreased $0.1 million and$0.4 million for the quarter and six months ended June 30, 2004 comparedto the same periods in 2003.  Customersupport and maintenance revenue decreased $0.3 million and $0.1 million for thequarter and six months ended June 30, 2004 compared to the same periods in2003.  Total revenues (includingmaintenance and support) for the quarter and six months ended June 30,2004 from our SecureNet product line increased to$1.0 million and $2.1 million from $0.9 million and $1.9 million for the sameperiods in 2003, but were not sufficient to counteract a continued decline insales of our hardware-based products in connection with our shift in businessfocus.  Our first generation productsales, including PDS and SecureCom decreased for thequarter and six months ended June 30, 2004 to $0.1 million and $0.2million from $0.7 million and $1.3 million from the same periods in 2003.  In addition, continued sluggish economicconditions and delayed customer orders contributed to the decline in revenues.

 

**ExportRevenues**.  Export revenues for the quarter and sixmonths ended June 30, 2004 decreased to $0.2 million and $0.6 million from$0.5 million and $1.3 million compared to the same periods in 2003 as revenuesfrom our PDS security appliance family decreased and we focused more of ourresources domestically.

 

**Concentration of Revenues**.  Revenues from sales to variousU.S. government entities totaled $0.4 million, or 37.6% of revenues, for thequarter ended June 30, 2004 compared to $0.2 million, or 13.6% ofrevenues, for the same period in 2003. Revenues from sales to Computer Science Corporation totaled $0.1 millionor 10.3% of revenue for the quarter ended June 30, 2004 compared to $44thousand or 3.0% of revenue for the same period in 2003.  We expect our concentration of revenues tovary among customers in future quarters depending upon the timing of certainsales.

 

**Gross Profit**.  Gross profit was $0.5 million or 47.7% of netrevenues for the quarter ended June 30, 2004, compared to $0.4 million or26.4% of net revenues for the quarter ended June 30, 2003. Gross profitwas $1.2 million or 48.8% of net revenues for the six months endedJune 30, 2004, compared to $0.9 million or 29.2% of net revenues for thesix months ended June 30, 2003. Gross profit margins as a percentage ofnet revenues increased from the same period in the prior year due to acontinued shift in product mix, which resulted in an increase as a percentageof revenues of our more profitable SecureNet productline.  Gross profit on product revenuesfor the quarter ended June 30, increased from 7.3% in 2003 to 29.7% in2004 due to the transition to our more profitable software-based products.  Gross profit on customer support andmaintenance revenues for the quarter ended June 30,

 

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increased from 47.0% in 2003 to 73.0% in2004, as less repair costs were incurred during the quarter in conjunction withour transition to software-based products.

 

Gross profit as a percentageof net revenues is impacted by several factors, including shifts in productmix, changes in channels of distribution, revenue volume, fluctuations inthird-party assembly costs, pricing strategies, and fluctuations in revenues ofintegrated third-party products.

 

**Sales and Marketing**.  Sales and marketing expenses decreased to$1.0 million for the quarter ended June 30, 2004, compared to $1.9 millionfor the quarter ended June 30, 2003. Sales and marketing expensesdecreased to $2.0 million for the six months ended June 30, 2004, comparedto $3.8 million for the six months ended June 30, 2003. This costreduction was primarily due to the reorganization of our sales and marketing departments,including a reduction in headcount, and other cost reduction initiatives.  We expect to continue to realize the impactof our cost reduction initiatives throughout 2004.  Sales and marketing expenses may vary as apercentage of net sales in the future.  However,we believe that these costs will remain relatively constant through the end ofthe year.

 

**Research and Development**.  Research and developmentexpenses decreased to $0.7 million for the quarter ended June 30, 2004,compared to $0.9 million for the quarter ended June 30, 2003. Research anddevelopment expenses decreased to $1.3 million for the six months endedJune 30, 2004, compared to $1.8 million for the six months endedJune 30, 2003. Research and development costs are expensed in the periodincurred.  Research and developmentexpenses decreased in the quarter and six months ended June 30, 2004,compared to the same periods in 2003 as we focused more of our developmentefforts on our core SecureNet software-based securityproducts and our regulated information compliance products, while reducingefforts on our PDS, SecureCom and otherhardware-based security products. Research and development expenses may vary asa percentage of net sales in the future.

 

**General and Administrative**.  General and administrativeexpenses decreased to $0.3 million for the quarter ended June 30, 2004,compared to $0.4 million for the quarter ended June 30, 2003.  General and administrative expenses decreasedto $0.6 million for the six months ended June 30, 2004, compared to $0.8million for the six months ended June 30, 2003.  This decrease was primarily due to therestructuring done in 2003, including a reduction in headcount, and other costreduction initiatives.  It is expectedthat general and administrative expenses will remain relatively constantthroughout the remainder of the year, as no further headcount reductions areanticipated.  General and administrativeexpense may vary as a percentage of net sales in the future.

 

**Severance Costs.**** **Severance costs decreased to $34 and $130 thousand for the three andsix-month periods ended June 30, 2004, compared to $118 and $244 thousandfor the quarter and six months ended June 30, 2003.  Severance costs during the three- andsix-month periods ended June 30, 2004 consisted primarily of severancepayments made during the periods as a result of reductions in force.  All severance obligations were paid prior toJune 30, 2004, and we were not receiving further benefit from these individualsafter June 30, 2004.  Severancecosts for the three and six-month periods ended June 30, 2003 consisted ofreductions in force made during those periods.

 

**Interest**.  Net interest income decreased to $7 thousandfor the quarter ended June 30, 2004 compared to $53 thousand for the sameperiod in 2003.  Net interest incomedecreased to $26 thousand for the six months ended June 30, 2004 comparedto $114 thousand for the same period in 2003. The decrease in interest income was primarily due to the decrease inoverall cash balances over the prior

 

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year. Net interest income may vary in the future based on our cash flow andrate of return on investments.

 

Liquidity and CapitalResources

 

Our principal source ofliquidity at June 30, 2004 is approximately $1.6 million of cash and cashequivalents and $3.1 million of short-term investments.  As of June 30, 2004 working capital was$4.3 million compared to $5.8 million as of June 30, 2003.

 

Cash used in operations forthe six months ended June 30, 2004 was $2.6 million, primarily due to anoperating loss of $2.8 million, an increase in inventories of $0.1 million anda decrease in accounts payable and accrued expenses of $0.6 million.  This cash usage was partially offset bydepreciation expense of $0.1 million, a decrease in accounts receivable of $0.4million, an increase in deferred revenue of $0.1 million and a decrease inother assets of $0.2 million.  Cash usedin operations of $4.6 million for the six months ended June 30, 2003, wasprimarily due to an operating loss from continuing operations of $5.7million.  This cash usage was offset bydepreciation expense of $0.9 million, recovery of accounts previously writtenoff of $0.3 million and decreases in accounts receivable of $1.7 million andother assets of $0.4 million, offset by an increase in inventories of $0.1million, a decrease in accounts payable and accrued liabilities of $0.9 millionand a decrease in deferred revenue of $0.5 million.  Future fluctuations in inventory balances,accounts receivable and accounts payable will be dependent upon severalfactors, including, but not limited to, quarterly sales, our strategy inbuilding inventory in advance of receiving orders from customers, and theaccuracy of our forecasts of product demand and component requirements.

 

Cash used in investingactivities in the six months ended June 30, 2004 was $1.5 million, whichconsisted primarily of the net purchase of short-term investments of $1.4million, compared to cash provided by investing activities of $2.7 million forthe six months ended June 30, 2003, which consisted primarily of thematurity of short-term investments.

 

Cash provided by financingactivities in the six months ended June 30, 2004 was $4.7 million,consisting of net financing proceeds from a private placement of $4.7 millionand the exercise of employee stock options of $6 thousand.

 

At June 30, 2004, theCompany did not have any material commitments for capital expenditures.

 

During the six months endedJune 30, 2004, the Company funded its operations through the use of cashand cash equivalents.

 

Based on our financialprojections, we expect that our cash on hand, along with our short-terminvestments, and cash from our operations will be sufficient to fund ouroperations for the next 12 months. However, our projections are dependent upon our ability to meet ourrevenue and gross profit targets.  Wefunded our operations and met our cash requirements during the quarter byselling a portion of our short-term investments.  Although we believe we have sufficient cashresources to finance our operations and expected capital expenditures for thenext twelve months, based on our internal estimates and our operating plan, thesufficiency of our cash resources may depend to a certain extent on generaleconomic, financial, competitive or other factors beyond our control.  Moreover, despite actions to reduce our costsand improve our profitability, we expect our operating losses and net operatingcash outflows to continue through 2004. As a

 

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result, we may not be able to achieve therevenue and gross margin objectives necessary to achieve positive cash flow orprofitability without obtaining additional financing.  We do not currently have any arrangements forfinancing, and we may not be able to secure additional debt or equity financingon terms acceptable to us, or at all, at the time when we need suchfunding.  If our business does notgenerate sufficient cash flow from operations and sufficient future financingsare not available, we may not be able to operate or grow our business, pay ourexpenses when due or fund our other liquidity needs.

 

We intend to explore thepossible acquisitions of businesses, products and technologies that are complementaryto our existing business.  We arecontinuing to identify and prioritize additional security technologies which wemay wish to develop, either internally or through the licensing or acquisitionof products from third parties.  While weengage from time to time in discussions with respect to potential acquisitions,there can be no assurances that any such acquisitions will be made or that wewill be able to successfully integrate any acquired business.  In order to finance such acquisitions andworking capital it may be necessary for us to raise additional funds throughpublic or private financings.  Any equityor debt financings, if available at all, may be on terms, which are notfavorable to us and, in the case of equity financings, may result in dilutionto our stockholders.

 

Factors That May AffectFuture Results of Operations 

 

Numerous factors may affectour business and future results of operations. These factors include, but are not limited to, current economic andmarket conditions, the effect of military actions on government and corporatespending on information security products, spending patterns of, andappropriations to, U.S. government departments, technological changes,competition and market acceptance, acquisitions, product transitions, timing oforders, manufacturing and suppliers, reliance on outsourcing vendors and otherpartners, intellectual property and licenses, third-party products, dependenceon government customers, international operations, intellectual propertyissues, liquidity and cash resources and effects of restructuring plans andcost reductions.  The discussion belowaddresses some of these and other factors. For a more thorough discussion of these and other factors that mayaffect our business and future results, see the discussion under the caption“Factors That May Affect Future Results of Operations” in our Annual Report onForm 10-K for the year ended December 31, 2003.

 

***If we fail to respond to rapid technological changes in the networksecurity industry, we may lose customers or our products may become obsolete.***

 

The network securityindustry is characterized by frequent product introductions, rapidly changingtechnology and continued evolution of new industry standards.  We must also introduce upgrades to ourproducts rapidly in response to customer needs such as new computer viruses orother novel external attacks on computer networks.  In addition, the nature of the networksecurity industry requires our products to be compatible and interoperable withnumerous security products, networking products, workstation and personalcomputer architectures and computer and network operating systems offered byvarious vendors, including our competitors. As a result, our success depends upon our ability to develop and introducein a timely manner new products and enhancements to our existing products thatmeet changing customer requirements and evolving industry standards. Thedevelopment of technologically advanced network security products is a complexand uncertain process requiring high levels of innovation, rapid response andaccurate anticipation of technological and market trends.  We cannot assure you that we will be able toidentify, develop, manufacture, market or support new or

 

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enhanced products successfully in a timelymanner.  Further, we or our competitorsmay introduce new products or product enhancements that shorten the life cycleof our existing products or cause our existing products to become obsolete.

 

***Our revenues have declined from $16.7 million in 2001 to $6.5 millionin 2003 and to $2.4 million for the six months ended June 30, 2004 from$3.0 in the same period in 2003 in connection with a shift to sales of ournewer product lines. If our network intrusion detection and regulatedinformation compliance system products do not achieve market acceptance, ourrevenues will suffer.***

 

Over the past three years,we have transitioned our sales strategy from our lower margin SecureCom and PDS security appliance products to thedevelopment and sales of our higher margin SecureNetnetwork intrusion detection products. During this transition, sales of our new products were not enough tocounteract the loss in sales associated with our older products.  As a result, our net revenues have declinedfrom approximately $16.7 million in 2001, to approximately $7.8 million in 2002and approximately $6.5 million in 2003. In addition, our revenues for the first half of 2004 are $2.4 million ascompared to $3.0 million for the same period in 2003.

 

Our new network securityproducts and regulated information compliance systems have only been in themarket place for a limited period of time and may have longer sales cycles thanour previous products.  Although responseto our products has been positive, we have not yet received broad marketacceptance.  We cannot assure you thatour present or future products will achieve market acceptance on a sustainedbasis.

 

In order to achieve marketacceptance and achieve future revenue growth, we must introduce complementarysecurity products, incorporate new technologies into our existing product linesand design, develop and successfully commercialize higher performance productsin a timely manner.  We cannot assure youthat we will be able to offer new or complementary products that gain marketacceptance quickly enough to avoid decreased revenues during current or futureproduct introductions or transitions.

 

***We resemble a developmental stage company and our business strategy maynot be successful.***

 

From our founding in 1983until 2000, we derived substantially all of our revenue from the design,manufacture and sale of local area networking equipment.  In order to permit us to focus our resourcessolely on developing and marketing our network security products, onApril 17, 2000, we announced our plans to sell our local area networkingassets and related networking divisions.

 

As a result of these sales,we now depend exclusively on revenues generated from the sale of our networks securityproducts, which have received limited market acceptance.  Moreover, we have only recently introducedour regulated information compliance systems, and the market for these productshas only begun to emerge.  Consequently,we resemble a developmental stage company and will face the following inherentrisks and uncertainties:

 

•                  the need for our network security products andregulated information compliance systems to achieve market acceptance andproduce a sustainable revenue stream;

 

•                  our ability to manage costs and expenses;

 

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•                  our dependence on key personnel;

 

•                  our ability to obtain financing on acceptableterms; and

 

•                  our ability to offer greater value than ourcompetitors.

 

Our business strategy maynot successfully address these risks.  Ifwe fail to recognize significant revenues from the sales of our networksecurity products and regulated information compliance systems, our business,financial condition and operating results would be materially adverselyaffected.

 

***We had a net loss of $2.8 million and an accumulated deficit of $47.0million as of the six months ending June 30, 2004.  As a result, we must generate substantiallygreater revenues from sales in order to achieve profitability.***

 

We have incurred significantoperating losses and are uncertain about our future operating results.  For the six months ended June 30, 2004,we incurred a net loss of $2.8 million and had an accumulated deficit ofapproximately $47.0 million at June 30, 2004.  In addition, our revenues have declined from$16.7 million in 2001, to $7.8 million in 2002, and $6.5 million in 2003.  We need to generate and sustain substantiallygreater revenues from the sales of our products if we are to achieveprofitability.  If we are unable toachieve these greater revenues, our losses will continue indefinitely, and wemay never achieve or sustain profitability or generate positive cash flow.

 

***We face intense competition from both start-up and establishedcompanies that may have significant advantages over us and our products.***

 

The market for networksecurity solutions is intensely competitive. There are numerous companiescompeting with us in various segments of the data security markets, and theirproducts may have advantages over our products in areas such as conformity toexisting and emerging industry standards, interoperability with networking andother security products, management and security capabilities, performance,price, ease of use, scalability, reliability, flexibility, product features andtechnical support.

 

Our principle competitors inthe network intrusion and detection market include Internet Security Systems,Inc., Cisco Systems, Inc., Symantec, Inc., NetscreenTechnologies, Inc., Tipping Point Technologies Inc. and NFR Security, Inc.  The market for regulated informationcompliance systems is relatively new. Our competitors in this market include a number of startup companies that have entered the market in the last two years.  However, as this market develops, we expectincreased competition from both start up andestablished companies.  Our current andpotential competitors may have one or more of the following significantadvantages over us:

 

•                  greater financial, technical and marketingresources;

 

•                  better name recognition;

 

•                  more comprehensive security solutions;

 

•                  better or more extensive cooperative relationships;and

 

•                  larger customer base.

 

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Although we believe that ourfocus on network perimeters with market leading VPN/firewall control technologyand network intrusion detection visibility technology that reduce the totalcost of ownership provides us with an advantage with large organizations withcomplex security requirements, we cannot assure you that our products willachieve market acceptance or that we will be able to compete successfully withour existing or new competitors.

 

***Military actions may disrupt our business by reducing spending ourproducts, increasing our costs and affecting our international operations.***

 

United States militaryactions or other events occurring in response to or in connection with them,including future terrorist attacks, actual conflicts involving the UnitedStates or its allies or military or trade disruptions could impact ouroperations by:

 

•                                       reducing or delaying government or corporatespending on network security products;

 

•                                       increasing the cost and difficulty inobtaining materials or shipping products; and

 

•                                          affecting our ability to conduct business internationally.

 

Should these events occur,our business, operating results and financial condition could be materially andadversely affected.

 

***Our products can have long sales and implementation cycles, which mayresult in us incurring substantial expenses before realizing any associatedrevenues.***

 

The sale and implementationof our products to large companies and government agencies typically involves alengthy education process and a significant technical evaluation and commitmentof capital and other resources.  Thisprocess is also subject to the risk of delays associated with customers’internal budgeting and other procedures for approving capital expenditures,deploying new technologies within their networks and testing and accepting newtechnologies that affect key operations. As a result, sales and implementation cycles for our products can belengthy, and we may expend significant time and resources before we receive anyrevenues from a customer or potential customer. Our quarterly and annual operating results could be materially harmed iforders forecasted for a specific customer for a particular period are notrealized.

 

***Our cash, cash equivalents, and investments have increasedapproximately $2.1 million in the last six months but have generally declinedsince 2003.  As a result of our expectedcontinuing net cash outflows, we may not have sufficient cash to operate ourbusiness.***

 

During the six months endedJune 30, 2004, our cash, cash equivalents and short-term investmentsincreased to approximately $4.7 million from approximately $2.7 million as ofDecember 31, 2003, primarily as a result of a private placement of ourpreferred stock and warrants we completed on March 25, 2004.  As of December 31, 2003, we had cash,cash equivalents and investments in the amount of approximately $2.7 million,down from approximately $10.7 million as of December 31, 2002.  Although we believe the proceeds we receivedin connection with the private placement will provide us with sufficient cashresources to finance our operations for the next twelve months, based on ourinternal estimates and our operating plan, the sufficiency of our cashresources may depend to a certain extent on general economic, financial,competitive or other factors beyond our control. Moreover, despite our actionsto reduce costs and improve profitability,

 

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we expect our net operating losses and netoperating cash outflows to continue through 2004.  We do not currently have any further arrangementsfor financing, and we may not be able to secure additional debt or equityfinancing on terms that are acceptable to us, or at all, at the time when weneed this financing.  If our businessdoes not generate sufficient cash flow from operations and sufficient financingresources are not available, we may not be able to operate or grow ourbusiness, pay our expenses when due or fund our other liquidity needs.

 

***Our failure to realize the expected benefits of our recentrestructuring efforts could adversely affect our operating results.***

 

During the first half of2004, we continued a restructuring plan and cost reduction efforts, whichresulted in $0.1 million in severance costs. Since we began restructuring in 2002, we have incurred approximately $0.8million in restructuring charges, severance, and related expenses. Theobjective of our restructuring plan was to reduce our cost structure to asustainable level that is consistent with our current cash resources and thegeneral economic climate.  We have alsoimplemented other strategic initiatives to strengthen our operations, such asreductions in our work force and facilities and aligning our organizationaround our business objectives.  Anyfurther work force reductions could result in temporary reduced productivity ofour remaining employees.  Additionally,our customers and prospects may delay or forgo purchasing our products due to aperceived uncertainty caused by our restructuring and other changes.  Failure to achieve the desired results of ourinitiatives could seriously harm our business, results of operations andfinancial condition.

 

***Consolidation in the network security industry may limit marketacceptance of our products.***

 

Several of our competitorshave acquired security companies with complementary technologies in the past,and we expect consolidation in the network security industry to continue in thefuture.  These acquisitions may permitour competitors to accelerate the development and commercialization of broaderproduct lines and more comprehensive solutions than we currently offer.  Acquisitions of vendors or other companieswith which we have a strategic relationship by our competitors may limit ouraccess to commercially significant technologies.  Further, business combinations in the networksecurity industry are creating companies with larger market share, customerbases, sales forces, product offerings and technology and marketing expertise,which may make it more difficult for us to compete.

 

***Sales to government agencies accounted for 38.5% of our revenues thesix months ended June 30, 2004 and 17% of our revenues for the year endedDecember 31, 2003.  Sales togovernment customers involve unique risks, which could adversely impact ourrevenues.***

 

We derived 38.5% of ourrevenues from sales to various U.S. government entities for the six monthsended June 30, 2004, and 17.0% of our revenues from these sales for theyear ended December 31, 2003.  Weexpect to continue to derive a substantial portion of our revenues from U.S.government customers in the future. Sales to the government present risks in addition to those involved insales to commercial customers, including potential disruption due toappropriation and spending patterns and hegovernment’s right to cancel contracts and purchase orders for itsconvenience.  General political andeconomic conditions, which we cannot accurately predict, directly andindirectly may affect the quantity and allocation of expenditures by federaldepartments.  In addition, obtaininggovernment contracts may involve long purchase and payment cycles, competitive

 

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bidding, qualification requirements, delaysor changes in funding, budgetary constraints, political agendas, extensivespecification development and price negotiations and milestonerequirements.  Each government entityalso maintains its own rules and regulations with which we must comply andwhich can vary significantly among departments. As a result, cutbacks or re-allocations in the federal budget or lossesof government sales due to other factors could have a material adverse effecton our revenues and operating results.

 

***We derived 26.3% of our revenues from international sales in the sixmonths ended June 30, 2004, and 31.4% of our revenues from these sales forthe year ended December 31, 2003. Our ability to sell our products internationally aresubject to certain risks which could harm our business.***

 

Sales to foreign customersaccounted for approximately 31.4% of our revenues for the year endedDecember 31, 2003, and 26.3% of our revenues for the six months endedJune 30, 2004.  Although exportsales decreased for the three and six month periods ended June 30, 2004when compared to the same periods in 2003, we expect sales to foreign customersto continue to represent a significant portion of our revenues in thefuture.  Our international operations aresubject to many inherent risks that may adversely affect our business,financial condition and operating results, including:

 

•                  political, social and economic instability;

 

•                  trade restrictions;

 

•                  increases in duty rates and other potentially adversetax consequences;

 

•                  exposure to different legal standards, particularlywith respect to the protection of intellectual property;

 

•                  burdens of complying with a variety of foreign laws;

 

•                  unexpected changes in regulatory requirements;

 

•                  import and export license requirements andrestrictions of the United States and each other country where we operate;

 

•                  fluctuations in currency exchange rates; and

 

•                  changes in local purchasing practices, includingseasonal fluctuations in demand.

 

***Sales through indirect channels accounted for 30.4% of our revenues forthe six months ended June 30, 2004 and 57% of our revenue for the yearended December 31, 2003.  Ourrevenues will suffer if we do not expand our sales through, or receive theanticipated benefits from our sales through, indirect sales channels.***

 

We derived 30.4% of ourrevenues for the six months ended June 30, 2004, and 57% of our revenuefor the year ended December 31, 2003 from sales through indirect saleschannels, such as distributors, value added resellers, system integrators,original equipment manufacturers and managed service providers.  We believe we must expand our sales throughthese indirect channels in order to increase our revenues.  Although we are actively pursuing a strategyto increase the percentage of our revenues generated through these indirectsales channels, we

 

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cannot assure you that our products willgain market acceptance in these indirect sales channels or that sales throughthese indirect sales channels will increase our revenues as expected.  Further, many of our competitors are alsotrying to sell their products through these indirect sales channels, whichcould result in lower prices and reduced profit margins for sales of ourproducts.

 

***We must adequately protect our intellectual property in order toprevent loss of valuable proprietary information.***

 

We rely on a combination ofpatent, copyright, trademark and trade secret laws, confidentiality proceduresand non-disclosure agreements to protect our proprietary technology.  However, unauthorized parties may attempt tocopy or reverse engineer aspects of our products or to obtain and useinformation that we regard as proprietary. Policing unauthorized use of our products is difficult, and we cannot becertain that the steps we have taken will prevent misappropriation of ourintellectual property.  This isparticularly true in foreign countries where the laws may not protectproprietary rights to the same extent as the laws of the United States and maynot provide us with an effective remedy against unauthorized use.  If our protection of our intellectual propertyproves to be inadequate or unenforceable, others may be able to use ourproprietary developments without compensation to us, resulting in potentialcost advantages to our competitors.

 

***We may incur substantial expenses defending ourselves against claims ofinfringement.***

 

There are numerous patentsheld by many companies relating to the design and manufacture of networksecurity systems.  Although we are notaware of any instances in which our products violate the intellectual propertyrights of others or inappropriately use their technology, it is possible thatthird parties in the future may claim that our products infringe on theirintellectual property rights.  Any claim,with or without merit, could consume our management’s time, result in costlylitigation, cause delays in sales or implementations of our products or requireus to enter into royalty or licensing agreements.  Royalty and licensing agreements, if requiredand available, may be on terms unacceptable to us or detrimental to our business.  Moreover, a successful claim of productinfringement against us or our failure or inability to license the infringed orsimilar technology on commercially reasonable terms could seriously harm ourbusiness.

 

***Fluctuations in our quarterly revenues may cause the price of ourcommon stock to decline.***

 

Our operating results havevaried significantly from quarter to quarter in the past, and we expect ouroperating results to vary from quarter to quarter in the future due to avariety of factors, many of which are outside of our control.  Although our revenues are subject tofluctuation, significant portions of our expenses are not variable in the shortterm, and we cannot reduce them quickly to respond to decreases in revenues.  Therefore, if revenues are below ourexpectations, this shortfall is likely to adversely and disproportionatelyaffect our operating results. Accordingly we may not attain positive operating margins in futurequarters.  Any of these factors couldcause our operating results to be below the expectations of securities analystsand investors, which likely would negatively affect the price of our commonstock.

 

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***The price of our common stock has been volatile in the past and maycontinue to be volatile in the future due factors outside of our control.***

 

The market price of ourcommon stock has been highly volatile in the past and may continue to bevolatile in the future.  For example,since August 1, 2003, the market price of our common stock on The Nasdaq  SmallCapMarket has fluctuated between $0.91 and $5.52 per share.  The market price of our common stock mayfluctuate significantly in response to a number of factors, many of which areoutside our control, including:

 

•                  variations in our quarterly operating results;

 

•                  changes in estimates of our financialperformance by securities analysts;

 

•                  changes in market valuations of our competitors;

 

•                  announcements by us or our competitors of new products,significant contracts, acquisitions, strategic relationships, joint ventures orcapital commitments;

 

•                  product or design flaws, product recalls or similaroccurrences;

 

•                  additions or departures of key personnel;

 

•                  sales of common stock in the future; and

 

•                  fluctuations in stock market prices and volume, which canbe particularly common among network security and other high technologycompanies.

 

***Our recent reductions in our work force may make it more difficult forus to attract and retain the personnel necessary to successfully operate ourbusiness.***

 

We rely upon the continuedservice of a relatively small number of key technical, sales and seniormanagement personnel.  Our future successdepends on retaining our key employees and our continuing ability to attract,train and retain other highly qualified technical, sales and managerialpersonnel.  We have employment agreementswith relatively few**of our keytechnical, sales and senior management personnel.  As a result, our employees could resign withlittle or no prior notice.  We may not beable to attract, assimilate or retain other highly qualified technical, salesand managerial personnel in the future, especially given our recent reductionsin force.  The loss of any of our keytechnical, sales and senior management personnel or our inability to attract,train and retain additional qualified personnel could seriously harm ourbusiness.

 

***Certain rights of the holders of 5% convertible preferred stock mayhinder our ability to raise additional financing.***

 

We cannot issue shares ofcapital stock with rights senior to those of our existing preferred or incurcertain indebtedness without the approval of at least a majority of the holdersof our 5% convertible preferred stock. In addition, holders of the preferred stock who are not executive officersor directors have the right to purchase a pro rata portion of certain futureissuances of securities by us.  Thecombination of these provisions could hinder or delay our ability to raiseadditional debt or equity financing.

 

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***You will experience substantial dilution upon the conversion of theshares of preferred stock and exercise of warrants that we issued in a privateplacement.***

 

On March 25, 2004, wecompleted a $5,000,000 private placement in connection with which we issued1,000,000 shares of our 5% Convertible Preferred Stock and warrants to acquire556,619 shares of our common stock.  Theconversion price for the preferred stock and the exercise price of the warrantsis $3.144 per share.  We also issued ourplacement agent a warrant for 64,408 shares of our common stock at an exerciseprice of $3.144 per share.  As a result,we expect the private placement to result in dilution to holders of our commonstock upon conversion of the preferred stock and exercise of the warrants of2,221,358 shares of common stock, or an approximately 43% increase in thenumber of shares of our common stock outstanding.

 

***The conversion of preferred stock or exercise of warrants we issued inthe private placement may cause the price of our common stock to decline.***

 

Upon the effectiveness ofthe registration statement related to this prospectus, the holders of preferredstock and warrants we issued in the private placement will be able to freelyconvert their shares of preferred stock and exercise their warrants and selltheir underlying shares of common stock. For the four weeks ended on July 30, 2004, the average dailytrading volume of our common stock on The NasdaqSmallCap Market was 7,505 shares.  Consequently, if holders of preferred stockor warrants elect to convert their shares or exercise their warrants and sell amaterial amount of their underlying shares of common stock on the open market,the increase in selling activity could cause a decline in the market price ofour common stock.  Furthermore, thesesales, or the potential for these sales, could encourage short sales, causingadditional downward pressure on the market price of our common stock.

 

***The percentage of our revenues attributable to sales of PDS productsintegrated with software of Check Point Software Technologies decreased from29.1% in 2002 to 16.7% in 2003 and from 24.7% for the first half of 2003 to9.5% for the first half of 2004.  Becausesales of our newer products may not offset the reduced sales of our PDSproducts, a change in our relationship with Check Point could have a negativeeffect on our operating results.***

 

Our PDS family of securityappliances, which are integrated with Check Point Software Technologies’market-leading VPN-1®/FireWall-1® software, represented    % of our revenues for the six months endedJune 30, 2004, and 16.7% of our revenues for the year endedDecember 31, 2003.  These percentagesare down from    % of our revenues forthe six months ended June 30, 2003, and 29.1% of our revenues for the yearended December 31, 2002.  We expectthe percentage of our sales attributable to our PDS products to decline in thefuture; however, our reliance on newer product sales may not replace theanticipated decline in revenue from sales of our PDS products.  Although we are a certified appliance partnerof Check Point and our PDS products have received Check Point certification, wehave no long-term agreement or exclusive relationship with Check Point.  As a result, the loss or significant changein our relationship with Check Point, the failure of our PDS products tomaintain or receive Check Point certification, the business failure of CheckPoint or its acquisition by or of one of our competitors and the loss of marketshare of Check Point or market acceptance of its products could each have amaterial adverse effect on our business, financial condition and results ofoperations.

 

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***Our acquisition of complementary products or businesses may adverselyaffect our financial condition.***

 

We have made acquisitions inthe past, and, in the future, we may acquire or invest in additional companies,business units, product lines or technologies to accelerate the development ofproducts and sales channels complementary to our existing products and saleschannels.  Negotiation of potentialacquisitions and integration of acquired products, technologies or businessescould divert our management’s time and resources.  Future acquisitions could cause us to issueequity securities that would dilute your ownership of us, incur debt orcontingent liabilities, amortize intangible assets or write off in-processresearch and development, goodwill and other acquisition-related expenses thatcould seriously harm our financial condition and operating results.  Further, if we are not able to properlyintegrate acquired products, technologies or businesses with our existingproducts and operations, train, retain and motivate personnel from the acquiredbusiness or combine potentially different corporate cultures, we may notreceive the intended benefits of our acquisitions, which could adversely affectour business, operating results and financial condition.

 

***The payment of accrued dividends on our 5% convertible preferred stockmay strain our cash resources.***

 

Shares of our 5% convertiblepreferred stock accrue cash dividends equal to $0.25 per share per annum.  These dividends are payable in arrears onMarch 31 and September 30 of each year, commencing onSeptember 30, 2004.  Delaware lawprovides that we may only pay dividends out of our capital surplus or, if nosurplus is available, out of our net profits for the fiscal year the dividendis declared and/or the preceding fiscal year. We have not had net profits for the last two fiscal years, and as ofJune 30, 2004 our capital surplus, defined as the amount by which our netassets exceed our stated capital, was approximately $3.7 million.  Therefore, we have only limited resources topay these dividends.  In addition, thepayment of these dividends could strain our available cash resources, whichcould adversely affect our ability to operate or grow our business.

 

***Compliance with export regulations may hinder our sales to foreigncustomers.***

 

Certain of our data securityproducts incorporate encryption and other technology that may require clearanceand export licenses from the U.S. Department of Commerce under United Statesexport regulations.  Any inability toobtain these clearances or licenses or any foreign regulatory approvals, ifrequired, on a timely basis could delay sales and have a material adverseeffect on our operating results.

 

***Provisions of our charter documents and Delaware law may haveanti-takeover effects.***

 

Certain provisions of ourcertificate of incorporation and bylaws, such as our ability to offer “blankcheck” preferred stock and the inability of our stockholders to act by writtenconsent, could make it more difficult for a third party to acquire us, even ifdoing so would be beneficial to our stockholders.  We are also subject to the provisions ofSection 203 of the Delaware General Corporation Law, which restrictscertain business combinations with interested stockholders and could inhibit anon-negotiated merger or other business combination.

 

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***Our management and larger stockholders exercise significant controlover our company and may approve or take actions that may be adverse to yourinterests.***

 

As of June 30, 2004,our executive officers, directors and 5% stockholders beneficially ownapproximately 38.5% of our voting power. As a result, these stockholders will be able to exercise significantcontrol over all matters requiring stockholder approval, including the electionof directors and approval of significant corporate transactions, which coulddelay or prevent someone from acquiring or merging with us.  These stockholders may use their influence toapprove or take actions that may be adverse to your interests.

 

Item3.                                QUANTITATIVE AND QUALITATIVE DISCLOSURESABOUT MARKET RISK

 

**Foreign Exchange**.  Revenue originating outside the U.S. in thequarters ended June 30, 2004 and 2003 was 15.4% and 33.4 % of totalrevenues, respectively. Revenue originating outside the U.S. in the six monthsended June 30, 2004 and 2003 was 26.3% and 42.4% of total revenues,respectively. International sales are made mostly from our foreign salessubsidiaries in the local countries and are typically denominated in U.S.dollars.  These subsidiaries incur mostof their expenses in the local currency.

 

Our international businessis subject to risks typical of an international business, including, but notlimited to: differing economic conditions, changes in political climate,differing tax structures, other regulations and restrictions and foreignexchange rate volatility.  Accordingly,our future results could be materially adversely affected by changes in theseor other factors.  The effect of foreignexchange rate fluctuations on us in 2004 and 2003 was not material.

 

On January 1, 2003, theCompany elected to change the functional currency of its foreign operations tothe United States dollar. This change in functional currency is supported bythe fact that all foreign operations are funded monthly in United Statesdollars and the majority of a revenue contracts are denominated in UnitedStates dollars.  Under United Statesdollar functional currency, the financial statements of foreign locations are remeasured from the recording currency to the United Statesdollar. The resulting remeasurement adjustment isrecorded as foreign exchange gain or loss in the statement of operations. Thereis no translation adjustment to the separate component of stockholders’ equityor adjustment to comprehensive income. The effect of the change in functionalcurrency had no material impact on results of operations. The accumulation ofprior years’ translation adjustments remains on the balance sheet as a separatecomponent of stockholders’ equity until part, or all, of the respectiveentities are disposed.

 

**Interest Rates**. We invest ourcash in a variety of financial instruments, including bank time deposits, fixedrate obligations of corporations, municipalities, and state and nationalgovernmental entities and agencies.  Theseinvestments are denominated in U.S. dollars. Cash balances in foreign currencies overseas are operating balances andare invested in short-term time deposits of the local operating bank.

 

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Interest income on ourinvestments is carried in “Interest income, net”.  We account for our investment instruments inaccordance with SFAS No. 115, “Accounting for Certain Investments in Debt andEquity Securities”.  All of the cashequivalents and short-term investments are treated as available-for-sale underSFAS 115.

 

Investments in fixed rateinterest earning instruments carry a degree of interest rate risk.  Fixed rate securities may have their fairmarket value adversely impacted due to a rise in interest rates.  Due in part to these factors, our futureinvestment income may fall short of expectations due to changes in interestrates or we may suffer losses in principal if forced to sell securities, whichhave seen a decline in market value due to changes in interest rates.  Our investment securities are held forpurposes other than trading.  Theweighted-average of the stated coupon interest rate on investment securities atJune 30, 2004 was 6.0%.  Due to theamortization of premiums and discounts paid, the actual rate of return willvary from the weighted-average of the stated coupon interest rate.  The fair value of investments held atJune 30, 2004 approximated amortized cost.

 

Item4.                                CONTROLS AND PROCEDURES

 

We have carried out anevaluation, under the supervision and the participation of our management,including our Chief Executive Officer and Chief Financial Officer, of theeffectiveness of our disclosure controls and procedures as of June 30,2004, pursuant to Rule 13a-15(b) under the Exchange Act.  Based upon that evaluation, our ChiefExecutive Officer and Chief Financial Officer concluded that our disclosurecontrols and procedures are effective in ensuring that information required tobe disclosed is recorded, processed, summarized and reported in a timelymanner.

 

We have carried out anevaluation, under the supervision and participation of our management,including our Chief Executive Officer and Chief Financial Officer, of anychanges in our internal controls over financial reporting that occurred duringthe quarterly period ended June 30, 2004, and our Chief Executive Officerand Chief Financial Officer have concluded that there was no change during thequarterly period ended June 30, 2004 that has materially affected or isreasonably expected to materially affect our internal control over financialreporting.

 

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**PART II****– OTHER INFORMATION**

 

Item1.                                LEGAL PROCEEDINGS

 

We are subject to legalproceedings and claims that arise in the ordinary course of business.  We do not believe that the outcome of thosematters will have a material adverse affect on our consolidated financialposition, operating results or cash flows. However, there can be no assurance such legal proceedings will not havea material impact.

 

Item 4.                                                             SUBMISSIONOF MATTERS TO A VOTEOF SECURITY HOLDERS

 

The Annual Meeting ofStockholders was held on May 29, 2004, at the Radisson Hotel, Dallas North inRichardson, Texas.  The following is abrief description of each matter voted upon by stockholders, including a numberof votes cast for, against, or withheld with regard to each matter of nominee.

 

(1)                                  Election of five (5) directors to serve untilthe next Annual Meeting of Stockholders and until their respective successorsare duly elected and qualified.

 
| ** **         | ** ** | **FOR**   | ** ** | **WITHHELD** | ** ** |
|--------------------|------------|-----------|------------|--------------|------------|
| G. Ward Paxton     |       | 6,631,093 |       | 12,839       |       |
| T. Joe Head        |       | 6,631,545 |       | 12,387       |       |
| James F. Gero      |       | 6,609,921 |       | 34,011       |       |
| J. Fred Bucy, Jr.  |       | 6,609,361 |       | 34,571       |       |
| Donald M. Johnston |       | 6,609,771 |       | 34,161       |       |

 

(2)                                  Ratification and approval of selection by theBoard of Directors of KBA Group LLP as independent auditors of the Registrantfor the fiscal year ending December 31, 2004.

 
| **FOR**   | ** ** | **AGAINST** | ** ** | **ABSTAIN** | ** ** |
|-----------|------------|-------------|------------|-------------|------------|
| 6,577,411 |       | 29,879      |       | 36,642      |       |

 

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Item6.                                EXHIBITS AND REPORTS ON FORM 8-K

 

(a)                                      The following Exhibits are filed with thisreport form 10-Q:

 

 

| 31.1 |   | Certification of Chief  Executive Officer Pursuant to Rule 13a-14(a) of the Exchange Act.                                                                                                              |
|------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 31.2 |   | Certification of Chief  Financial Officer Pursuant to Rule 13a-14(a) of the Exchange Act.                                                                                                              |
| 32.1 |   | Certification of Chief  Executive Officer Pursuant to Rule 13a-14(b) of the Exchange Act and 18  U.S.C. Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002. |
| 32.2 |   | Certification of Chief  Financial Officer Pursuant to Rule 13a-14(b) of the Exchange Act and 18  U.S.C. Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002. |

 

(b)                                     During the quarter ended June 30, 2004,we did not file any reports on Form 8-K:

 

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**S I G N A T U R E S**

 

Pursuant to the requirementsof the Securities Exchange Act of 1934, the Registrant has duly caused thisreport to be signed on its behalf by the undersigned, thereunto duly authorized.

 

 
| ** **                 | **INTRUSION INC.**                                                   |
|----------------------------|----------------------------------------------------------------------|
|                       |                                                                 |
|                       |                                                                 |
| Date: August 13, 2004 | /s/  Michael L. Paxton                                               |   |
|                       | Michael  L. Paxton                                                   |
|                       | Vice President, Chief  Financial Officer,  Treasurer & Secretary |
|                       | (Principal  Financial & Accounting Officer)                      |

 

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